The waters are muddied further by another fundamental problem. For most schemes, liabilities are calculated infrequently, using out-of-date longevity assumptions and ad hoc discount rates, and often presenting a less than prudent valuation of the true costs of delivering pensioners full financial security. As people live longer—15 minutes more for every passing hour by some estimates—and accounting standards move more toward valuing balance sheets on a mark-to-market basis, the immediately calculable costs can rise dramatically as outdated assumptions are revised.
Many pension schemes value their liabilities by using a discount rate that is implicitly linked to the assumed return on their assets. The problem is that they are effectively banking on an uncertain set of future gains to pay off their obligations to millions of current and future pensioners. Even worse, the discount rates vary from scheme to scheme. Some may choose a point in time and a single discount rate for all their liabilities, while others may choose to be more sophisticated and look at evolving discount rates over time. Regardless, most discount rates are ultimately linked to AA-rated corporate bond yields—the result of an implicit belief that returns of this order can be harvested without difficulty.
This is not to say that corporate bonds are not good investments. They are an investment staple with good reason and can provide low-risk returns. However, they are not risk-free, and any prudent investor needs to be cognizant of the default, credit, and liquidity risks that go with the asset class. In recent months, the problem has been highlighted by the credit crunch, which has seen prices of AA corporate bonds collapse and their yields soar. No wonder many schemes were feeling pleasantly flush and in surplus over the last couple of years—their liabilities dramatically lessened over the same time period!
It’s a false optimism. The downturn in prices reflects the increasing fear that some of these corporate bonds might default. Even if one claimed that investing everything in AA corporate bonds today could still provide these returns at low risk, there simply aren’t enough around. Taking the United Kingdom as an example, the total value of AA corporate bonds floating around the British financial markets at last count was just over $142 billion—a fraction of the some $1,200 billion of liabilities they are supposed to underpin.
It’s a troubling mismatch problem. Although there is a tradition of pension schemes and insurers “booking” some potential asset gains in advance, it is important for companies not to bank on future gains to work out their liabilities. An unembellished picture of the liabilities, stripped of any assumed risk premiums, can often be a good guide when setting investment targets and managing the risk on your balance sheet.
The area is also coming under increased regulatory scrutiny, with more stringent accounting standards being imposed. For example, the pensions regulator in the United Kingdom is now pushing schemes to adopt more realistic mortality assumptions that reflect the latest scientific evidence—a change that could equate to an additional cost of $40 billion for the UK defined benefit industry with every added year of life expectancy. This also presents additional shorter-term risks for sponsors, as they may have to divert extra cash into the scheme to meet these future liabilities via a contribution notice.